The Value of Corporate Control: Evidence from Control Transaction Cases in Chinese Firms

Transcription

1 The Value of Corporate Control: Evidence from Control Transaction Cases in Chinese Firms CHOI, Chi Kit «A Thesis Submitted in Partial Fulfillment of the Requirement for the Degree of Master of Philosophy in Economics The Chinese University of Hong Kong August 2007 The Chinese University of Hong Kong holds the copyright of this paper. Any person(s) intending to use a part or whole of the materials in the paper in a proposed publication must seek copy right release from the Dean of the Graduate School.

2 [ Q 1 SEP 18 ) i ^ ^ university/g/ YO^XLIBRARY SYCTEMy>^

3 ABSTRACT The existence and the magnitude of the value of corporate control have been broadly debated in the literature, but few of them address China. The existing studies follow two routes: calculate the value of corporate control from dual class share prices or from a comparison of the transfer prices of controlling block shares and non-controlling shares. However, in almost all the studies adopting the latter approach, the research design cannot address the impact of liquidity effect well. This potentially makes the estimation of the value of corporate control misleading. Major shareholders of Chinese companies usually hold illiquid non-tradable shares; and their block shareholdings are sometimes transferred to other parties. The special feature of the Chinese stock market in the dichotomy of tradable and non-tradable shares provides a unique setting to study the value of corporate control with the liquidity effect separated out. In this thesis, we analyze the value of corporate control in China by using 95 block transfers during 1999 to Similar to the previous research, we found that there exists a positive premium of corporate control in China. Control block transactions in China are priced 14% higher than non-control block transactions on average. Cross-sectional regression analysis shows that the value of corporate control in China varies positively with the largest shareholder's controlling power. The block acquirers are also paying a higher price for companies located in poorly-govemed regions or having poor corporate governance practices. Similar to the case in Poland, control premium in China is higher in companies with relatively poor performance prior to block transfers. i

4 摘要 不同學術硏究均曾討論公司控制權的價値, 但只有少數硏究提及中國 現有硏究主要從兩方面作探討 : 一是硏究不同表決權股份的價差, 二是硏究控制性股權轉讓與不涉及控制性股權轉讓的交易差價 但是, 幾乎所有採取後者方法的硏究都未能有效控制因持有大量股份所衍生的流通性效應, 從而令控制權價値的量度或有所偏差 中國上市公司的主要股東擁有的主要爲非流通的股份, 而這些股份只有不定期的轉讓 非流通股份的存在令大股東持股所衍生的流通性效應減至最小, 並提供了一個獨特的硏究機會 本文利用 95 宗從 1999 年到 2004 年期間發生的股權交易硏究中國公司控制權的價値 相似於先前的硏究, 我們發現涉及最大股東轉換的股權交易作價比不涉及最大股東轉換的股權交易平均高出 14% 橫截面回歸分析顯示, 中國公司控制權的價値與最大股東的控制力量有著正面的關係 股權交易買家亦願意以較高的價格收購公司治理較差或位於地區治理較差的公司 與波蘭相似, 中國公司控制權的價値與交易前的公司表現是有著反向關係的 ii

5 Acknowledgement I would like to express my gratitude to my thesis supervisor, Professor Du Julan, for his kind guidance, invaluable suggestions and continuous supports for making this thesis possible. I would also like to thank Professor Rui Meng for his kind guidance and invaluable advices during the research. I am also grateful to have Professor Zhang Jun for his insightful suggestions and invaluable comments on improving the thesis. A special thanks is dedicated to my family members for their permanent supports and encouragement during my work. iii

6 Contents 1. Introduction 1 2. Literature Review 5 3. Research Hypothesis 3.1 Institutional Setting Existence and magnitude of the value of corporate control Determinants of the value of corporate control Methodology 4.1 Testing the existence of value of corporate control Typical eamples Testing the determinants of value of corporate control Controlling Power Regional Governance Corporate Governance Firm Performance Control variables Data 5.1 Existence of value of corporate control Determinants of value of corporate control Controlling Power Regional Governance Corporate Governance Firm Performance Control variables Empirical Results 6.1 Existence of value of corporate control Robustness tests Determinants of value of corporate control Controlling Power Regional Governance Corporate Governance Firm Performance Multivariate regression analysis Summary and Conclusion References Appendix 52 iv

7 vii Tables Table 1 Summary of different control premium measures 52 Table 2 Composition of the sample - company information 53 Table 2.1 Block pairs identified per company Table 2.2 Stock Exchange distribution of the companies Table 3 Composition of the sample company industry distribution 54 Table 4 Composition of the sample - company location distribution 55 Table 5 Composition of the sample - block information 56 Table 5.1 Controlling Block Size Table 5.2 Time difference between control and non-control block transaction Table 6 Data description on controlling power variables 57 Table 7 Regional Governance Indices 58 Table 8 Data description on corporate governance variables 59 Table 8.1 b_h 一 share Table 8.2 CEO_is_chair Table 8.3 indep_dir_% Table 9 Data description on firm performance data 60 Table 10 Data description on control variables 61 Table 10.1 Descriptive statistics on asset value and debt-to-equity ratio Table 10.2 Acquirer Identity Table 11 Existence of value of corporate control t-test 62

8 Table 12 Robustness test normalization by different market exchange 63 prices Table 13 Robustness test - limitation on allowing only one transfer-pair 64 for each company Table 14 Robustness test excluding auction transactions 65 Table 15 Simple Regression Analysis 66 Table 16 Univariate Analysis 67 Table 17 Multivariate Regression Analysis 68 Table 18 Interplay between regional and corporate governance 73 Table 19 Interplay between acquirer identity and other explanatory variables 了 ^ Table 20 Correlation Matrix 79 vi

9 1. INTRODUCTION The value of corporate control has been broadly debated in the corporate finance literature. Traditional finance theory suggests that shareholders receive benefits in proportion to their fractional ownership, and in this sense, there should not be any additional value for having the controlling power of a corporation. However, modem studies show that some controlling shareholders are willing to pay a control premium for the controlling power. It is generally agreed in the literature that the control premium is associated with the private benefits of control. Various studies in the corporate finance literature discuss private benefits of control and identify different forms of it. Jensen and Meckling (1976) link the private benefits with the perquisites enjoyed by the top executives. Harris and Raviv (1988) and Aghion and Bolton (1992) reveal that some shareholders achieve private benefits of control because they enjoy the pleasure of commanding a corporation. Johnson et al. (2000) provide empirical evidence that controlling shareholders can extract private benefits by tunneling - the diversion of corporate resources from the corporation (or its minority shareholders) to the controlling shareholder. However, controlling power also comes with private costs, and in some cases, it can make the net private benefits negative (Barclay and Holdemess, 1989). One of the major sources of the private cost comes from an under-diversified portfolio. The largest shareholder often holds a controlling block of shares and makes itself underdiversified. Liquidity cost of holding block shares can also decrease the control 1

10 premium observed as block shares being less liquid. Other private costs include the potential legal liability incurred as well as the risk of reputation loss. Private benefits of control are difficult to observe and measure directly. A controlling party will only extract private benefits from corporate resources if and only if it is difficult to verify and prove (Dyck and Zingales, 2004). Two major methods have been widely used to quantify value of corporate control. The first method uses firms with multiple classes of shares having different voting rights. Then, the value of corporate control can be easily quantified by observing the market price differences between shares with different voting rights (Lease et al, 1983, Zingales, 1994,Nenova, 2003). The second method, introduced by Barclay and Holdemess (1989), quantify the value of corporate control as the differences between the price of controlling block share transfers and the market exchange price, and infer it as the private benefits of control. The value of corporate control varies among studies. Barclay and Holdemess (1989) analyze the pricing of 63 block trades between 1978 and 1982 and find that block trades are priced, on average, 20% higher than the post-announcement exchange prices. Nenova (2003) uses a sample of 661 dual-class firms in 18 countries in 1997 and documents that the premium of control-block varies from around 0% in Finland to around 50% in South Korea. Dyck and Zingales (2004) use 393 control transactions in 39 countries between 1990 and 2000 and find that the average value of corporate control is 14%, with a range from -4% in Japan to 65% in Brazil. 2

11 Although there are a vast number of studies about the value of corporate control, few of them address China. As a rising economic power, China restored its stock market at the end of 1990 and it is still on the way to match the rules and regulations of the stock markets with those of developed financial markets. At the moment, stocks in China are typically dichotomized into tradable liquid shares and non-tradable illiquid shares. Two types of share are identical in every aspect, except that those illiquid shares cannot be sold in the secondary market. This thesis studies the value of corporate control in China's listed companies. The prevailing approaches to the estimation of value of corporate control are either measuring the price difference between voting shares and non-voting shares or estimating the price difference between block share transfers and market price of stocks. However, both approaches involve inherent weakness. First, the price premium of voting shares over non-voting shares does not necessarily incorporate corporate control rights based on block share ownership. Second, in almost all other economies, the premium of block share transfer price over stock market price involves the effect of liquidity in selling block shares. In contrast, the majority of shares in China's listed companies, namely state-owned shares and legal person shares, are non-tradable and thus illiquid. In this thesis, we compare the transfer prices of block share transfers leading to largest shareholder change and those of transfers not doing so in China's listed companies to compute the value of corporate control. This could most accurately reflect the value of corporate control right by overcoming the shortcomings of the prevailing two approaches in the literature. 3

12 In this thesis, we analyze block transfer cases of Chinese companies between 1999 and We discriminate those cases into two types, cases which are associated with control transaction and cases which are not. We match each block transfer, which is associated with control transaction, with another block transfer of the same company, which does not involve control transaction, in order to investigate the value of corporate control. During the five years time-span, 95 block transfer pairs from 76 companies are identified. We basically follow the rationale pioneered by Barclay and Holderaess (1989) to test the existence and magnitude of control premium in China. It is observed that controlling block (block transfers that associated with control transaction) in China are, on average, priced 14% higher than non-controlling block (block transfers that do not involve with control transaction). Multivariate regression analysis reveals that the value of corporate control increases with the controlling power of the block acquirer and decreases with the profitability of the target firm. The control premium will also decrease if the target company is located in regions with better regional governance while it will increase if the target company has poor corporate governance practices. The remainder of the thesis is organized as follows. Section 2 briefly reviews the relevant literature about value of corporate control and private benefits. The main hypotheses are derived in Section 3. We describe the methodology and data in Section 4 and Section 5 respectively. Section 6 outlines the empirical results of statistical tests. We will summarize the findings and conclude the thesis in Section 7. 4

13 2. LITERATURE REVIEW Traditional finance theory assumes that ownership of publicly traded companies is diffuse and there is a separation between ownership and control. Corporate decisions are made by professional managers who proposed to act in the interest of the diffuse shareholders. However, research has shown that a number of public corporations have large block shareholders, which influence the management structure and have the ownership and controlling power simultaneously. It is also found that those cases are not limited to a few small firms, but also exist in large and well-known corporations. Block shareholdings are sometimes transferred and it had become the focus of some research in corporate finance. Throughout the literature, it is observed that some block-share buyers are willing to pay a control premium for acquiring the controlling power, and it is usually associated with the private benefits of corporate control. Barclay and Holderness (1989) analyze the pricing of 63 block trades between 1978 and 1982 in United States. They find that the blocks are typically priced at a substantial premium relative to the post-announcement exchange price, with an average of 20%. They also perform multivariate regression analysis to identify the determinants of block premium. It is found that the premium increases at a decreasing rate with firm size and at an increasing rate with fractional ownership. Better prior trade performance also increases the control premium. The authors also found that the premium differs between individual and corporate buyers, apparently 5

14 because of individuals' limited capital and risk aversion. Individuals are willing to pay a larger premium if the target firm is more leveraged, has a lower stock-return variance or with a larger balance of cash and marketable securities at the time of trade. Nicodano and Sembenelli (2000) analyze 94 block transactions from 64 manufacturing companies in Italy between 1987 and The average premium of the block transfers is 27.4% when compared with the post-transaction market price. The authors dichotomize the sample into two sub-samples according to the block size and found that the premium is larger when a larger size of block shares is traded. Company's net worth as well as the existence of non-voting equity also has a significant positive relationship with the premium. Trojanowski (2003) analyzes 53 block trades during in Poland and contributes to one of the few block premium analyses in the emerging markets. Although block premium is expected to be high in emerging markets because the financial system is weaker and it is easier to extract private benefits in emerging market, the result is reversed. The observed block transfers are priced, on average, 6.8% above the post-trade exchange price which is relatively lower than that in other countries. The author argued that the presence of liquidity costs faced by block holders may decrease the private benefits of holding equity blocks. Dyck and Zingales (2004) perform international comparisons about the value of corporate control. Using 393 control transaction cases between 1990 and 2000 in 39 countries, they find the average value of corporate control is around 14%, ranging 6

15 from -4% to 65% in different countries. They find that lower private benefits of control are associated with better accounting standards, better legal protection of minority shareholders as well as better law enforcement. A high level of press diffusion, a high rate of tax compliance as well as more intense product market competition will also decrease the value of corporate control. As different countries have different levels of financial development, the authors also test several theoretical propositions about the effects between private benefits of control and the development of financial markets. Their results align with major theoretical propositions that higher private benefits of control are associated with less developed capital markets, more concentrated ownership and privately negotiated privatizations. Massari et al. (2006) extend the Barclay and Holdemess (1989) approach to study the control premium in Italy, in which transfer of control is regulated by law. They analyze the pricing of 27 control transactions in Italy between 1993 and It is found that the average control premium is around 8%. The authors also investigate the cross-sectional variation of the control premium and find that the value of corporate control varies positively with the target firm's degree of stockpyramiding, and negatively with the target firm's size. It is also found that the control premium tends to be larger when the acquirer is a strategic buyer as opposed to a financial buyer. Apart from using the method pioneered by Barclay and Holdemess (1989) which focuses on the transfer of controlling blocks in publicly traded companies, there are also a vast amount of literature makes use of companies with multiple 7

16 classes of shares that have different voting rights to analyze the value of corporate control. Lease et al. (1983) analyze 30 publicly-traded corporations that have two classes of common stock between 1940 and The two classes of stock are identical except having different voting abilities. Four corporations in the sample also have outstanding voting preferred stocks. For the 26 firms that have two classes of common stock outstanding, the authors find that common stock with superior voting rights are traded at an average premium of 5.44%, while the 4 firms that have an additional class of voting preferred stocks, the result reverses and records an 1.25% discount. The authors explain the results by suggesting that there are both costs and benefits of corporate control, and the price differences may reflect unequal indirect cash or non-cash payoffs to different shareholders. Megginson (1990) examines 152 British firms that have two or more common share classes with different voting rights between 1955 and With more than 16,000 monthly price pairs, the author finds that the superior voting shares are having a premium of 13.3% over the restricted voting shares. The author also provides regression analysis to analyze the determinants of the voting premium. It is found that the voting premium is increased with insider holdings of superior voting shares and decreased with insider holdings of restricted voting shares, while other variables like total asset value are not significant. Zingales (1994) analyzes all the companies having both voting and nonvoting shares traded on the Milan Stock Exchange (MSE) between 1987 and

17 companies having dual-class shares are observed and the average premium of voting right is 82%. The result is far larger than other studies, and the author argues that private benefits are particularily large in Italy while the competition for control is also particularly intense. It also provides an alert that careful comparison is needed when we try to compare the value of corporate control across different financial systems. Nenova (2003) measures the value of corporate voting rights by using 661 dual-class firms in 18 countries in The average value of corporate controlblock votes varies greatly across countries, from -3% in Hong Kong to 48% in South Korea. The author also finds that there is a negative and significant relationship between the value of corporate control and tougher rule of law, stricter general investor protection laws, stricter investor-friendly takeover laws, and the absence of power-concentrating charter provisions. measures. Table 1 summarizes different studies on control premium and private benefit [Insert Table 1 Here] 9

18 3. Research Hypothesis 3.1 Institutional setting As a part of China's economic reform, China re-started its stock market in late 1990 in Shanghai and early 1991 in Shenzhen. After 17 years of development, there are already 1472 listed companies in the two exchanges that contribute a total of RMB 16 trillion (about $2.1 trillion) market capitalization in April However, among the RMB 16 trillion market capitalization, the tradable shares valued only 5.2 trillion which account for around one-third of the total market capitalization.' Prior to the opening of the two Stock Exchanges, China converted many state-owned enterprises into stock companies. However, concerns are raised about the potential loss of state assets if all the shares of state-owned enterprises are freelytraded. As a result, the ownership structure of a typical listed company in China is separated into three classes: state-owned shares, restricted institutional shares and common shares. Both the state-owned shares and restricted institutional shares are non-tradable in the market while the general public can only trade the common A- and B-share in the stock exchange. Among the three classes of shares, holders are entitled with the same cash flow and voting power. The only difference between different classes of shares is the transferability. Both state-owned shares and restricted institutional shares can only be transferred through private placement and auction between corporate and legal-entity institutions. A-shares are freely tradable for domestic investors on the stock exchanges while B-shares are only tradable by foreign investors who use either U.S. dollars or Hong Kong dollars for settlement. Source: The Chinese Securities Regulatory Commission, wwvv.csrs.aov.cn 10

19 Consistent with previous literature, Chen and Xiong (2001) find that there exist illiquidity discounts for the non-tradable shares in China. The authors make use of restricted institutional shares transaction data from August 2000 to July 2001 and find that the average discount for restricted institutional shares is 77.93% on auction transfers and 85.59% on private transfers, compared with their common share counterparts. 3.2 Existence and magnitude of the value of corporate control In this thesis, we basically follow the method pioneered by Barclay and Holdemess (1989). Different from the voting right approach which compares the stock price of shares with different voting power, Barclay and Holdemess (1989) make use of large percentage block share transfer and compare the block trade price with the post-announcement exchange price. They argue that the difference represents the private benefits of control from block ownership. However, almost all block trades that happened in China involve illiquid state-owned shares or restricted institutional shares. The illiquidity as well as the large discount of those non-tradable shares makes direct employment of the Barclay and Holdemess (1989) method impossible. Aligned with their rationale, we use two separate block transactions within the same company, in which one of them involves control transfer and the other did not. We then normalize the block transfer prices with the market exchange prices. We infer the difference between the two prices as the value of corporate control in China. Detailed methodology employed is discussed in Section 4. 11

20 The unique ownership structure of Chinese listed companies provides an excellent setting to analyze the value of corporate control. Trojanowski (2003) argues that the liquidity cost of holding equity blocks decreases the value of corporate control observed in Poland, despite numerous deficiencies in corporate governance standards in that emerging country. The existence of liquidity effect can make the estimation of the value of corporate control misleading. Liquidity costs of holding block shares differ in difference countries and the problem enlarges in emerging markets. Different shareholding levels will also incur different liquidity costs which make direct comparison between block transfer prices and market exchange prices prone to error. By comparing two illiquid block share transfers in China, we can obtain a clean control premium without the contamination of the liquidity effect, and provide a unique measure of the value of corporate control with the liquidity effect separated out. In this thesis, we make use of China's unique ownership structure to analyze the value of corporate control in China, with the liquidity effect minimized. Similar to previous studies, we expect there exist a positive value of corporate control in Chinese firms, as block acquirers may be willing to pay a premium for acquiring controlling blocks in order to enjoy the controlling power or extract the private benefits of control. And it forms our first hypothesis: Hypothesis 1: A positive value of corporate control is observed in the Chinese market while the liquidity effect is minimized. 12

21 3.3 Determinants of the value of corporate control Apart from checking the existence and magnitude of control premium, we are also interested in the determinants of the value of corporate control. Previous studies show that there is a wide fluctuation of block premium between different companies, and we would like to identify the factors which would affect the value of corporate control in China and analyze their effects on it. We believe that the value of corporate control in China can be affected by four main types of factors: controlling power, regional governance, corporate governance and firm-specific performance. Block size varies while company ownership concentration also differs between companies. It is likely that the block acquirer would be willing to pay a higher premium if the block is large enough for it to exercise its controlling power. So, we hypothesize that the higher controllability the acquirer has, the easier for it to extract private benefits from the target company, which results in a higher control premium observed during block transfers. Hypothesis 2: The value of corporate control in China varies positively controlling power that the block buyer acquired. with the Despite the rapid market-oriented economic development in China, regional disparity exists and grows continuously. More developed regions like Shanghai and Guangdong achieved great economic development and have a relatively open and free economy. The level of government involvement or intervention in these regions 13

22 is relatively minimal when compared to the inner and western part of China, where the marketization progress is still very slow. Marketization progress in China helps to improve regional governance and provides a fair investment environment to potential investors. However, better regional governance may also hammer the potential private benefits extracted, and it may effectively decrease the control premium. Thus, it forms our third hypothesis. Hypothesis 3: The value of corporate control in China varies negatively with different locations regional governance level. Besides the macro-level regional governance, we also believe that the microlevel corporate governance will also play a role in determining the value of corporate control. Earlier studies show that general investors and market practitioners are willing to pay a premium to well-governed firms so that their interests will not be eroded by the management or executives. However, senior management or corporate owner can extract private benefits of corporate control through tunneling more easily if the company is weakly-govemed. So, we believe that weaker corporate governance of the target firm will increase the control premium, and it forms our fourth hypothesis. Hypothesis 4: The value of corporate control in China varies negatively with different companies corporate governance quality. Apart from controlling power, regional and corporate governance, firm performance would also affect the value of corporate control. The effect of a target 14

23 firm's profitability on the value of corporate control varies across different studies. Dyck and Zingales (2002) find that there exist a positive relationship between firm performance and the value of corporate control during their international analysis, while Trojanowski (2003) rejects this finding in the Polish data and finds that the relationship is negative. Trojanowski (2003) argues that the possibilities to extract private benefits of control in poorly performing companies are higher than in wellperforming companies in Poland. We believe that China's case may be more similar to those in Poland which both are on the track of economic transition towards a market economy. The ability of corporate owners to extract private benefits may be higher in poorly performing firms in China and thus, it forms our fifth hypothesis. Hypothesis 5: The value of corporate control in China varies negatively with target firm 's performance. This thesis plans to investigate these five hypotheses. The following sections of the thesis will discuss the methodology and data employed for the empirical testing of these hypotheses. 15

24 4. Methodology 4.1 Testing the existence of value of corporate control As discussed in hypothesis setting, this thesis tests the value of corporate control in China using the rationale pioneered by Barclay and Holdemess (1989). However, direct application of their methodology is impossible in China because of the illiquidity and discount observed in non-tradable shares. Barclay and Holdemess (1989) make use of the simple observation that differences exist between block exchange prices and the market prices traded in the stock exchange. They compare the block exchange prices with the postannouncement exchange prices and infer the differences as the value of private benefits of control. Price premium = ^^^,^ The comparison is intuitive and easy to understand, but cannot directly apply to China's case. Almost all block-share transfers in China involve non-tradable illiquid state-owned shares or restricted institutional shares which are traded at a large discount in negotiation-based block transfers when compared to the trading prices. This makes direct comparison between block-transfer prices and market exchange prices impossible. To compute the value of corporate control in China, we make use of two block-share transfers within the same company, one of which leads to controlling 2 Pb is the block-trade price and P the is post-announcement exchange price 16

25 shareholder change (referred as control block transfer) while another does not (referred as non-control block transfer). Since block shares are illiquid and not publicly transferable, we can minimize the liquidity cost problem encountered by previous studies and provide a clean measure of control premium. As time differences often exist between control block transfers and noncontrol block transfers, we normalize the observed block exchange prices by the post-announcement market exchange prices so as to do the comparison. This can control the variables that vary across time as block shares and shares traded in the stock exchange are only differed by the transferability. We call this measure of value of corporate control as normalized control premium. P P;' ifc Normalized control premium = ( ^ hr^^^w, P P P We match each control block transfer with non-control block transfer and compute the normalized control premium. In cases there exist more than one matching available, we would use the pair that have the shortest time difference between exchanges. This methodology aligns with the fundamental thinking of Barclay and Holdemess (1989) and helps us to investigate the existence and magnitude of the value of corporate control in China while minimizing the liquidity problem faced by previous studies. 4.2 Typical Examples 3 pc is the control-block exchange price, P^e jg the non-control block exchange price, pm is the market exchange price while the underscripts represent the time. 17

26 To better illustrate the usage of the normalized control premium, looking into some typical examples in our sample may be insightful. As discussed before, this thesis makes use of block transfers in China which involve control transaction. We interpret the value of corporate control as the price difference between control block transfer and non-control block transfer and investigate the existence, magnitude and determinants of the control premium. Shijianzhuang Quanyechang Company Limited ( 石家莊勸業場股份有限公司,stock code ) is one of the typical examples of our sample companies. Listed in Shanghai, the company had two block transfers in the spring of On 23rd March 2000, Baiquan Group Company of Hunan University ( 湖南大學百泉集團公司 ),which previously held no interest in Shijianzhuang Quanyechang, acquired 29.56% shares of the captioned company. This block transfer, valued at RMB 2 per share, helps the subsidiary of Hunan University to become the largest shareholder of Shijianzhuang Quanyechang while the seller of the block no longer holds any share of the company. We identify this block transfer as a control block transfer because the buyer of the block becomes the largest shareholder of the target company after the transfer. A month later, on 26''' April 2000, a company from Guizhou ( 貴州匯龄實業有限公司 )bought another block of shares in Shijianzhuang Quanyechang. 9.67% of the total shares were transferred at the price of RMB 1.2 per share, and the acquirer became the second largest shareholder effectively. We identify this block transfer as 18

27 a non-control block transfer as the buyer of the block has not become the largest shareholder of the target company after the transfer. It is easy to observe that, in this example, the control block is priced much higher than the non-control block (more than 60%). Such a comparison is intuitive and easy to understand but prone to the fundamental value change of the target company in the period between the two block transfers. The comparison may yield a wrong conclusion and will not be effective as the time difference between the two block transfers lengthened. So, as introduced in the methodology section, we make use of the market trading price to normalize the block transfer price before making the comparison. This method aligns with the fundamental thinking of the previous literature while taking the special feature of China's stock market into account. We will discuss this method in the next example. Shashi Power28 Company Limited ( 沙市活力二八股份有限公司,stock code ), listed in Shanghai Stock Exchange, experienced two block-share transactions in 2000 and 2003 respectively. On August 2000,an acquirer from Hubei ( 湖北天發集團公司 )purchased a block involving 45.43% of Shashi Power28,s shares and became the largest shareholder. Each share is priced at RMB 1.1 at that time. Nearly three years later, an investment company ( 信達投資有限公司 )purchased a non-control block shares (2.39% of the total shares) at RMB 1 on 7" June If we tried to compare the two block exchange prices directly, it is observed that the control block is priced at a 10% premium. However, such a comparison is 19

28 not effective as the time difference between the two transactions is so long that the fundamental value of the target company may have varied a lot. The introduction of market exchange prices in the comparison helps to solve the stated problem. The liquidity of the secondary market makes the exchange prices change rapidly in response to the fundamental corporate value. In this example, the post-announcement market exchange price after the control block transfer is RMB while the post-announcement market exchange price after the non-control block transfer is RMB As expected, the price difference between liquid and illiquid stocks is very large. If we normalize the block transfer prices with the market exchange prices, it is found that the normalized control premium is -34%. The result is totally different from the ordinary price premium. It is believed that the normalized control premium represents the true picture better and is more suitable for the cases in China. 4.3 Testing the determinants of value of corporate control As discussed in the previous section, another main part of this thesis is to identify the determinants of value of corporate control in China. In order to do so, we employ ordinary least square regression estimation to check the effect of twelve variables coming from four main categories, namely controlling power, regional governance, corporate governance and firm performance Controlling Power The shareholding of the largest shareholder is one of the most efficient measures about its controlling power in a company. Major corporate decision will be 20

29 made by shareholder voting, and a larger stake of ownership will essentially turn into a higher controlling power. So, we make use of the natural logarithm of the square of the largest shareholding after the controlling block share transfer as one of our measure of controlling power, and denote it as Absolute_power. Absolute power = In [(largest shareholder shareholding)" ] Apart from its own shareholding, the power of other shareholders will also affect the controlling power of the largest shareholder. To capture the joint-power effect of other shareholders, we make use of the natural logarithm of the sum of square of 2"'' to largest shareholding to represent the counter power that the largest shareholder faces and denote it as Countenng_power. 10 Countering_power = In^],1=2 [(n^* shareholder shareholding)"?] To capture both the largest shareholder shareholding effect and the jointpower shareholding effect from other shareholders in one single variable, we employ the use of Herfindahl index to measure the controlling power that the largest shareholder enjoyed. Denoted as Relative_power, it is defined as the difference between the Herfinaahl index of the largest shareholder's shareholding and the Herfindahl index of the 2"^ to lo"' largest shareholders' shareholding after the controlling block share transfer. It is clear that a higher Relative_power represents that the largest shareholder can exercise a higher degree of control of the corporation and face less counter-power from other shareholders. Relative_power = (largest shareholder shareholding)"? 10 -Yj h=2 [(n"' shareholder shareholding ] 21

30 4.3.2 Regional Governance The interaction between regional governance and the value of corporate control is one of the main interests of this thesis. As a rapidly growing economy, regional disparity within China is severe and various literature use different regional development index to study the marketization progress of different provinces and cities in China. In this thesis, we employ four different measures to capture the regional governance disparity in China, namely government intervention, contract enforcement, foreign investment and the regional government's effort in decreasing non-tax burden of the corporations. All of the variables used are taken during the year of the block share transfers which lead to controlling shareholder change. Government intervention in business operations is a frequently observed phenomenon around the world, especially in developing economies. It may lead to rent-seeking and even corruption problem. The independent controlling power of business owner is seriously affected if government intervention in business operations is severe and collusive agreement between government and corporations may exist. Both the daily operation of the corporation as well as the ability for the shareholders to extract private benefits will be hammered in the intervening environment. Thus, we include the variable Govtjntervention from Du et al. (2007), which is constructed based on data from the survey of China's Private Enterprises 22

31 ,in our regression analysis to investigate the effect of local government intervention on the value of corporate control. The variable Govt_Intervention is defined as the proportion of entrepreneurs requesting government help in case of business disputes. Government intervention in business operations could be indicative of either strong or weak protection of private properties. On the one hand, government help may fill the void created by the lack or weakness of the court system while on the other hand, government help may lead to rent-seeking and even corruption that entrepreneurs lobby or bribe government officials to seek favor in resolving business disputes. Apart from government intervention, legal institutions and law enforcement are also big issue that would exert large influence on corporate operations. Better contract enforcement protects transacting parties effectively, and it hinges on comprehensive legal institutions and effective law enforcement. Quality of legal institutions and degree of law enforcement vary significantly across regions in China and we include the variable Contract Enforcement from Du et al (2007), which is again from the survey of China's Private Enterprises, to capture the regional institutions and law enforcement information. The variable Contract Enforcement is defined as the proportion of private entrepreneurs answering affirmatively to the question: will you use courts to resolve business disputes? The amount of foreign investment is a good indicator about the market environment. Better regional governance, marketization progress and factor market development will attract more foreign investment. We make use of the data from Fan 4 This survey was conducted by the United Front Work Department of the Central Committee of the Communist Party of China, the All China Industry and Commerce Federation, and the China Society of Private Economy at the Chinese Academy of ^cial Sciences, in 1995, 1997,2000 and

32 et al. (2001) about foreign investment and include the variable Foreign Investment in our analysis to see the relationship between regional governance level and value of corporate control in China. The variable Foreign Investment is a score that calculated by the proportion of the value of foreign investment (include Hong Kong, Macau and Taiwan) to the total GDP of the region. Apart from various tax payments, corporations operate in different regions will have different non-tax burden. Locations with poor regional governance and weak property right protection will have higher non-tax burden which would benefit the local government. Corporate owners need to spend more time and money to do business in region with high non-tax payments while collusive agreement between corporate owners and local government may exist in those regions to extract different kinds of benefit through tunneling. We make use of the data from Fan et al (2001) about regional government's effort in decreasing non-tax burden in our analysis to investigate the effect of regional non-tax burden on value of corporate control in China, and denote the variable as DecreasingjionJax Corporate Governance Various previous studies discuss the corporate governance issue in China, and in this thesis, we would employ three main corporate governance measurements used in Bai et al. (2003) to investigate about the determinants of the size of control premium in China. All of the variables used for measuring corporate governance are taken just before the block share transfers which lead to controlling shareholder change. 24

33 The most common form of tradable shares in China is the A-share which can be traded by any mainland Chinese citizen. Some listed companies also issue B-share which is open mainly to foreign investors in domestic stock exchanges. A small proportion of companies even cross-list their shares in Hong Kong Stock Exchange by issuing H-shares. The regulatory and governance requirements are different between pure A-share firms and others. Most pure A-share companies are audited by local accounting firms where the standard is hardly guaranteed. On the other hand, companies with B-share or H-share must comply with the international accounting standards and better corporate governance is expected. So, we introduce the bjtjshare dummy variable as one of the corporate governance measures. b h share = ( "fa company has issued B or H shares 0 if otherwise Apart from the regulations a company faced, the composition of the board of directors, which acts as the main decision making and monitoring body, can also represent the corporate governance level of the firm. The monitoring role of the board of directors is compromised if the chief executive officer of the company is the chairman or vice-chairman of the board of directors and has full or partial control of the board. Therefore, we introduce the CEO_is_chair dummy variable to proxy the corporate governance level of a company, CEO_is chair = { 1 if CEO is the chairman or a vice chairman of the board of directors 0 if otherwise A higher degree of independence of the board of directors would also increase the monitoring power of the board. Independent directors are relatively free 25

34 from the management's pressure and help to improve the corporate governance level of a company. Thus, we introduce the indep_dir_% variable to measure the relative power of the independent directors in the board of directors of the target company. inde dir % = Number of independent directors in the board of directors - Total number of people in the board of directors Firm Performance Previous literature shows that firm performance will also alter the value of corporate control. In this thesis, we will use two main firm performance varfiables to check their effect on the valuation of control premium in China. Profitability is one of the most commonly employed variables when analyzing the determinants of the value of corporate control. It is believed that the firm performance prior to acquisition will affect the value of corporate control premium, and we use the return of equity {ROE) of the target firm as a proxy to its profitability. Apart from the magnitude of past performance, the stability of corporate earnings may also affect the value of corporate control. An investment will be more risky if the return is relatively unstable, and we try to capture the level of risk associated with the target company by the variable Profit_SD which is measured by the standard deviation of the 5-year pre-trade profit and normalized by the firm's total asset Control variables 26

35 In an attempt to control other un-captured effects, we include three specific variables in our regression analyses as control variables, namely firm size, leverage and acquirer identity. Firm size is one of the most widely used control variables in different studies. The inclusion of firm size in the regression analysis can help in controlling the differences between companies' fundamental value. We use the natural logarithm of asset value {In asset) of the target firm for firm size. The degree of leverage is another useful control variable. As a percentage of debt over the total equity value, the debt-to-equity ratio measures the debt burden and investment risk of the corporation, and we denote this variable as Leverage. Block acquirers in China are mainly state-owned companies or privatelyowned corporations. We include the dummy variable Private acquirer which equal to 1 if the block acquirer is privately-owned corporations and 0 otherwise to check if there exists any interaction between block acquirer identity and value of corporate control. Although acquirer identity itself may not have a clear impact on the valuation of control premium, the inclusion of this variable can certainly serve as a control variable to minimize other effects in the regression analysis. Simple and multivariate regression analyses are employed to investigate the effect of different variables on the value of corporate control. In the following sections, detail data description and the empirical results of different statistical tests will be discussed. 27

36 5. Data 5.1 Existence of value of corporate control We make use of the China Stock Market & Accounting Research Dataset (CSMAR) to identify block transfer transaction in China during 1999 to We supplement and validate the data by obtaining company annual reports through Shanghai and Shenzhen Stock Exchange. Each block transfer is identified as either involving control transaction or not. We then match each control block transfer with a non-control block transfer of the same company as discussed in the methodology. Throughout the five years time window, 95 block-pairs are identified from 76 companies. Among the 76 sample companies, 59 (77.6%) have only one block-pair observed during the five-year period, 15 (19.7%) have two pairs observed while only 2 (2.6%) companies have three block-pairs observed. When looking into the stock exchange distribution of these companies, 41 (53.9%) come from the Shenzhen Stock Exchange while the remaining 35 (46.1%) come from the Shanghai Stock Exchange. Table 2 summarizes the company information presented here. [Insert Table 2 Here] China Stock Market & Accounting Research Dataset classifies companies into six different industries, namely commerce, conglomerates, finance, industrials, properties and utilities. According to the classification, more than half of our sample 28

37 companies come from the industrial industry, constituting 59.2% of the sample, while none of the sample company is a financial institution. The second largest group among the sample companies is conglomerate company, making up 19.7% of the sample while 13.2% of the sample companies come from the commerce sector. Utility companies represent 5.3% of the total sample while property firms constitute the remaining 2.6%. Table 3 summarizes the industry distribution of the sample companies discussed above. [Insert Table 3 Here] The geographical distribution of the 76 sample companies is diverse. Shanghai and Sichuan contribute the largest number to the whole sample, each having 9 companies (11.8%) involved. The whole sample comes from 23 provinces and province-level cities and Table 4 shows a detailed geographical distribution of the sample. [Insert Table 4 Here] Regarding the composition of the 95 block-pairs, we find that the average size of the control block transfer involves 24.8% of the target company's shares with a median of 26.6%. The control block size ranges from a minimum of 4.3% to a maximum of 65.4% throughout the 95 sample companies. The average time difference between control block transfer and non-control block transfer is 0.97 years while the median is 0.42 years. About 80% of the time differences between 29